Tuesday, December 2, 2008

Will the Euro Survive? (Part II)

Back in early November I noted that Desmond Lachman was arguing that the global financial crisis increased the likelihood that the Eurozone would not survive in its current form. His argument was that since the Eurozone is not an optimal currency area the stresses from the financial crisis may crack it open. Martin Feldstein is now making a similar case (ht Mark Thoma):

CAMBRIDGE – The European Economic and Monetary Union (EMU) and the euro are about to celebrate their tenth anniversary. The euro was introduced without serious problems and has since functioned well, with the European Central Bank delivering the low inflation that is its sole mandate.

But the current economic crisis may provide a severe test of the euro’s ability to survive in more troubled times. While the crisis could strengthen the institutions provided by the EMU, it could also create multiple risks, of which member countries need to be aware if they want to avoid them.

The primary problem is that conditions in individual EMU members may develop in such different ways that some national political leaders could be tempted to conclude that their countries would be better served by adopting a mix of policies different from that of the other members. The current differences in the interest rates of euro-zone government bonds show that the financial markets regard a break-up as a real possibility. Ten-year government bonds in Greece and Ireland, for example, now pay nearly a full percentage point above the rate on comparable German bonds, and Italy’s rate is almost as high.

[...]

The most obvious reason that a country might choose to withdraw is to escape from the one-size-fits-all monetary policy imposed by the single currency. A country that finds its economy very depressed during the next few years, and fears that this will be chronic, might be tempted to leave the EMU in order to ease monetary conditions and devalue its currency. Although that may or may not be economically sensible, a country in a severe economic downturn might very well take such a policy decision.

Feldstein's article prompted me to go back and look at the Intrade contract that predicts whether "any country currently using the Euro [will] announce their intention to drop it on/before 31 Dec 2010." Here is the figure from the contract (click on figure to enlarge):

Not much change since early November, but still almost 40%. As noted before, there are some great articles on the future of the Euro found here.